Investors, economists and pundits are paying close attention to every ounce of information from the Federal Reserve, hoping to intuit what each new speech or research paper might mean for the direction of U.S. interest rates. In the wake of the Fed’s decision to leave rates unchanged at the September meeting, Viewpoints checked in with Bill Irving, a bond fund manager who runs Fidelity Government Income Fund (FGOVX), and Jurrien Timmer, our director of global macro, for their perspectives on where interest rates may be headed—and what it could mean for bond investors. Read the interview with Irving, or watch Timmer’s video commentary.
The Fed decided not raise rates in September. What was your take on the outcome from this meeting?
Irving: The Fed’s post-meeting statement noted that the committee “judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.” The decision appears to have been a close call, as three committee members dissented in favor of a hike. That is the most dissents in five years.
In Federal Reserve Chair Janet Yellen’s post-meeting press conference, she elaborated on why they did not raise rates. Measures of slack in the labor market have come down this year less than expected, which she attributed to acceleration in the number of people returning to the labor market. This gives the Fed more room to run, especially since inflation continues to run below the Fed’s 2% target.
Today, the Fed also updated its Summary of Economic Projections. This update comes quarterly. The median forecast is now for one rate hike this year and two next year, down from two and three hikes, respectively, in the June projections. The Fed also downgraded its projection for longer-run real GDP growth to 1.8% (from 2% previously) and for longer-run funds rate to 2.9% (from 3% previously). These more downbeat long-run projections are a continuation of a trend over the past year, as the Fed’s outlook moves more in line with market pricing.
My central forecast is for a rate hike in December, but that hike is by no means certain. The problem is that the latest round of U.S. economic data has been on the weak side. This weakness was reflected in the latest retail sales report, both the manufacturing and non-manufacturing ISM surveys, and in contracting industrial production. I would say the probability of a December hike is about 60%.
What else have we learned recently about the Fed’s thinking?
Irving: Of the other recent Fed comments, three have been really important. The first was from John Williams, president and CEO of the San Francisco Fed. He wrote a paper in August titled “Monetary Policy in a Low R-star World.” The key point of the paper is that in the Fed’s view, the natural rate of interest—the level at which rates don’t boost or slow the economy—has declined significantly in recent years. The critical implication of a lower natural interest rate is that conventional monetary policy has less latitude to stimulate the economy in the event of a downturn.
To provide some context, the Fed cut the federal funds rate by an average of 550 basis points during each of the previous nine recessions. At first blush, that’s not very encouraging since the current fed funds rate is only 50 basis points. Right now, if a downturn came, the Fed would have very little room to lower rates. Former Treasury Secretary Larry Summers said “we should be extremely worried. We are essentially on a dangerous battlefield with very little ammunition.”
In late August, Janet Yellen’s speech at the Jackson Hole Economic Symposium expressed a more balanced outlook. She bluntly confirmed what we’ve long suspected: Recent additions to the Fed’s toolkit—including forward guidance and quantitative easing measures like asset purchases—will remain very useful for providing additional accommodation in the future if interest rates head back toward zero.
Finally, Lael Brainard, a member of the Fed’s board of governors, gave a speech on September 12 at the Chicago Council on Global Affairs. The speech was called “The ‘New Normal’ and What it Means for Monetary Policy.” Its bottom line was that tightening monetary policy too quickly might do more damage to the economy than taking a slower route. It’s a dovish stance, suggesting that the Fed should raise rates with a very slow and cautious pace.
How does the uncertainty about interest rates change things for bond investors?
Irving: I think most bonds are on the expensive side right now. In the corporate credit sector, spreads are back to average levels, but credit quality is below average. Mortgage-backed securities are an alternative to credit, but the spreads on those securities look fair at best. Meanwhile, inflation-protected securities look cheap relative to conventional Treasuries, so they offer one opportunity.
I think yields will remain at historically low levels for some time. In that environment, I’d be cautious about reaching for yield. Spreads could widen in the event of another recession, presenting risks to the types of securities that offer higher yields.
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